Principles of Micro Economics: Interdependence and the Gains from Trade

Interdependence and the Gains from Trade

Overview

  • Focus on how trade can benefit economies

  • Provides examples using two individuals, Ruby and Frank, representing a cattle rancher and a potato farmer respectively.

A Parable for the Modern Economy

  • Goods: Only two goods are discussed -

    • Meat

    • Potatoes

  • Individuals: Only two people participating in the economy -

    • Ruby: A cattle rancher

    • Frank: A potato farmer

  • Goal: Both Ruby and Frank desire to consume both meat and potatoes.

Production Considerations

  • Isolated Production:

    • If Ruby produces only meat and Frank produces only potatoes, both gain from trade.

    • If both produce both goods, they can gain from specialization and trade.

  • Production Possibilities Frontier (PPF):

    • Represents the various mixes of output that an economy can produce.

Production Possibilities Frontiers

  • Figure 1 illustrates the production opportunities available to Frank and Ruby.

    • Time to Produce Goods:

    • Frank takes 60 minutes to produce 1 ounce of meat and 15 minutes for 1 ounce of potatoes.

    • Ruby takes 20 minutes for 1 ounce of meat and 10 minutes for 1 ounce of potatoes.

    • Production in 8 Hours:

    • Frank: 8 ounces of meat and 32 ounces of potatoes.

    • Ruby: 24 ounces of meat and 48 ounces of potatoes.

  • Production Possibilities: Panels (b) and (c) depict Frank's and Ruby's individual production possibilities frontiers assuming an 8-hour workday.

    • Without trade, each individual's production possibilities frontier equals their consumption possibilities frontier.

Comparative Advantage

  • Absolute Advantage:

    • Defined as the ability to produce a good using fewer inputs than another producer.

    • In meat production, Ruby has an absolute advantage as she uses 20 min vs Frank's 60 min.

    • In potato production, Ruby also has an advantage, using 10 min vs Frank's 15 min.

  • Comparative Advantage:

    • Defined as the ability to produce a good at a lower opportunity cost than another producer, reflecting relative opportunity costs.

    • Principle of Comparative Advantage:

      • Each good should be produced by the individual with the smaller opportunity cost.

      • Both individuals should specialize according to their comparative advantages.

Opportunity Cost Defined

  • Opportunity Cost:

    • Defined as whatever must be given up to obtain some item.

    • Trade-offs: Opportunity costs measure the trade-off between the two goods that each producer faces.

  • Example of Opportunity Cost for Frank and Ruby:

    • Frank:

    • 60 minutes for meat and 15 minutes for potatoes; thus, to produce 1 more ounce of meat, he gives up 4 ounces of potatoes.

    • To produce 1 more ounce of potatoes, he gives up 0.25 ounces of meat.

    • Ruby:

    • 20 minutes for meat and 10 minutes for potatoes; thus, to produce 1 more ounce of meat, she gives up 2 ounces of potatoes.

    • To produce 1 more ounce of potatoes, she gives up 0.5 ounces of meat.

Opportunity Costs Summary Table

  • Table 1: Summarizes the opportunity cost for Frank and Ruby:

    • Frank:

    • Opportunity cost for 1 ounce of meat is 4 ounces of potatoes.

    • Opportunity cost for 1 ounce of potatoes is 0.25 ounces of meat.

    • Ruby:

    • Opportunity cost for 1 ounce of meat is 2 ounces of potatoes.

    • Opportunity cost for 1 ounce of potatoes is 0.5 ounces of meat.

Specialization and Trade

  • Specialization Outcomes:

    • Frank specializes in growing potatoes resulting in more time allocated to potato production and less on cattle.

    • Ruby specializes in raising cattle allowing more time for cattle and less for potatoes.

  • Trade Example: Ruby and Frank agree to trade 5 ounces of meat for 15 ounces of potatoes.

Expanding Consumption Opportunities

  • Figure 2: Demonstrates how trade expands each individual's consumption opportunities:

    • Panel (a): Frank's production and consumption changes from point A to A*.

    • Panel (b): Ruby's production and consumption changes from point B to B*.

  • Outcomes:

    • The proposed trade allows each to consume more meat and more potatoes compared to their production without trade (point A vs A* for Frank and point B vs B* for Ruby).

Production and Consumption Comparison Without Trade

  • Without Trade:

    • Frank: 4 oz meat and 16 oz potatoes.

    • Ruby: 12 oz meat and 24 oz potatoes.

  • With Trade:

    • Frank has production of 0 oz meat and consumption of 32 oz potatoes, trade gives him 5 oz meat and 17 oz potatoes consumed.

    • Ruby has production of 18 oz meat and 12 oz potatoes, trade gives her 27 oz of potatoes and 13 oz of meat consumed.

  • Increase in Consumption: Gains from trade result in increased consumption across both individuals, e.g., 1 oz of meat and 3 oz of potatoes for Ruby.

Importance of Comparative Advantage

  • Critical Point: One individual may have an absolute advantage in both goods but cannot have a comparative advantage in both.

  • Differentiated Opportunity Costs: This difference leads to gains from specialization and trade, increasing total production in the economy and producing a larger economic pie, thus positively affecting all individuals involved.

Social Benefits of Trade

  • General Impact: Trade enables everyone in society to benefit by allowing specialization in areas where individuals have a comparative advantage.

  • Trade Prices: Must lie between the opportunity cost of the two goods.

  • Interdependence and Gains from Trade: The principle of comparative advantage provides insight into the interconnectedness of economies and the collective gains derived from trade.